Basel 1 - took care of credit risk
Basel 2 - took care of credit and marketers
Basel 3 - took care of the capital and the liquidity rules
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### What are Basel Norms?
The Basel Norms are a set of international banking regulations developed by the Basel Committee on
Banking Supervision (BCBS) to ensure that financial institutions have enough capital to meet
obligations and absorb unexpected losses. These norms provide guidelines on the minimum capital
requirements for banks, thereby promoting stability and efficiency in the financial system.
### History of Basel Norms
The Basel Norms originated with the establishment of the BCBS by the central banks of the G-10
countries in 1974, under the Bank for International Settlements (BIS). The formation of the
committee was a response to the bankruptcy of Herstatt Bank in Germany, which highlighted the
risks in international banking. Over the years, the Basel Norms have evolved through several
accords:
- **Basel I (1988)**: Focused on credit risk by creating a banking asset classification system based
on risk.
- **Basel II (2004)**: Introduced to address the shortcomings of Basel I, especially regulatory
arbitrage, by emphasizing three pillars—minimum capital requirements, supervisory review, and
market discipline.
- **Basel III (2010)**: Developed in response to the 2008 financial crisis, it introduced more
stringent capital requirements and new regulatory requirements for liquidity and leverage.
### Tier 1 and Tier 2 Capital in Basel I
- **Tier 1 Capital**: Also known as core capital, includes equity capital and disclosed reserves. It is
the most permanent and readily available capital to absorb losses.
- **Tier 2 Capital**: Includes revaluation reserves, general provisions, hybrid debt capital
instruments, and subordinated term debt. It is less permanent and serves as supplementary capital.
### Four Pillars of Basel I
1. **Constituents of Capital**: Defines the nature of eligible capital, divided into Tier 1 and Tier 2.
2. **Risk Weighting**: Assigns risk weights to different asset categories to determine capital
adequacy.
3. **Target Standard Ratio**: Sets the minimum capital adequacy ratio at 8%.
4. **Transitional and Implementing Arrangements**: Provides guidelines for the transition and
implementation of the norms.
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Q. what are capital and liquidity rules of basel3?
Ans: As per Basel 3, capital and liquidity rules are as follows –
Liquidity rules:
One of the objectives of Basel III accord is to strengthen the liquidity profile of the banking industry.
Hence, two standards of liquidity were introduced.
Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)
Liquidity Coverage Ratio (LCR): As per this, bank have to invest in such high-quality liquid assets
which can be easily converted to cash, the cash should be enough for next 30 days because Basel
compliance believe that bank can take corrective action within 30 days to withstand the situation.
Net Stable Funding Ratio (NSFR): The Net Stable Funding Ratio incentivizes banks to obtain financing
through stable sources on an ongoing basis. More specifically, the standard requires that a minimum
quantum of stable and risk less liabilities are utilized to acquire long term assets.
Capital Rules
Capital Conservation Buffer:
The intention behind the capital conservation buffer is to make certain that banks accumulate
capital buffers in times of low financial stress. Basel II incorporates a capital conservation buffer of
2.5 percent above the minimum capital requirement.
Countercyclical Buffer:
The underlying premise of the countercyclical buffer is that capital requirements in the banking
sector must take into consideration the macroeconomic environment in which banks operate. Banks
would be subject to a countercyclical buffer between zero and 2.5 percent of their total risk-
weighted assets.
What is the difference between Basel 2 and Basel 3?
Basel 3 enhances regulations over Basel 2 by introducing stricter capital and liquidity requirements,
with a greater focus on riskier assets.
Basel norms, also known as Basel Accords, are a set of international banking regulations developed
by the Basel Committee on Banking Supervision. These norms aim to ensure the stability and
soundness of the global banking system by establishing minimum standards for banks' capital
adequacy, risk management, and regulatory oversight. The Basel norms primarily consist of three
major iterations:
**Basel I:**
1. **Capital Requirements:**
Introduced the first global standard for minimum capital adequacy, requiring banks to hold capital
equal to at least 8% of their risk-weighted assets.
2. **Risk Weighting:**
Implemented a simple risk-weighting system for assets, categorizing them into different risk classes
with fixed weights to determine capital requirements.
3. **Credit Risk:**
Focused primarily on credit risk, ensuring that banks hold sufficient capital against potential loan
defaults and other credit exposures.
4. **Implementation:**
Adopted widely in the late 1980s and early 1990s, providing a basic framework for international
banking regulation.
Basel II is an international banking regulatory framework developed by the Basel Committee on
Banking Supervision (BCBS). It aims to enhance the regulation, supervision, and risk management
within the banking sector by establishing more stringent standards. The framework is built on
three pillars:
Pillar 1: Minimum Capital Requirements
This pillar focuses on maintaining sufficient capital to cover three major types of risks:
- **Credit Risk**: Risks from potential default by borrowers.
- **Market Risk**: Risks from changes in market prices.
- **Operational Risk**: Risks from internal failures, such as system breakdowns or fraud.
Pillar 2: Supervisory Review Process
This pillar emphasizes the need for regulatory oversight to ensure that banks have sound internal
processes to assess their capital adequacy relative to their overall risk profile. It allows regulators to
evaluate and intervene if necessary.
Pillar 3: Market Discipline
This pillar encourages transparency and disclosure, requiring banks to publicly disclose their risk
exposures, capital adequacy, and risk management practices. This transparency helps market
participants make informed decisions and promotes better market discipline.
Basel II is designed to strengthen bank capital requirements and risk management, thereby
enhancing the stability and soundness of the financial system.
**Basel III:**
Response to Financial Crisis: Introduced in response to the 2007-
2008 financial crisis to strengthen bank capital requirements and
introduce new regulatory requirements on bank liquidity and leverage.
It aims to strengthen regulation, supervision, and risk management within the banking sector. Here's
how you can explain it succinctly in an interview:
### Key Objectives:
- **Enhance Bank Resilience**: Basel III aims to improve the ability of banks to absorb shocks arising
from financial and economic stress.
- **Reduce Systemic Risk**: It seeks to reduce the risk of system-wide financial crises.
### Key Components:
1. **Higher Capital Requirements**:
- **Common Equity Tier 1 (CET1)**: Increased the minimum requirement for CET1 capital, which is
the highest quality of regulatory capital.
- **Capital Conservation Buffer**: Added an extra buffer of 2.5% of CET1 capital, bringing the total
minimum to 7%.
- **Countercyclical Buffer**: Introduced a buffer of up to 2.5% of CET1, which can be adjusted by
national regulators to protect the banking sector during periods of excessive credit growth.
2. **Leverage Ratio**:
- Introduced a minimum leverage ratio of 3% to limit the total leverage a bank can take on,
regardless of the risk of the assets.
3. **Liquidity Requirements**:
- **Liquidity Coverage Ratio (LCR)**: Requires banks to hold sufficient high-quality liquid assets to
cover net cash outflows over a 30-day stress period.
- **Net Stable Funding Ratio (NSFR)**: Ensures that banks maintain a stable funding profile
relative to the composition of their assets over a one-year period.
4. **Risk Management and Supervision**:
- Enhanced requirements for risk management and supervision to ensure better management of
risk and compliance with regulatory standards.
### Why It Matters:
- **Increased Stability**: By holding more and higher-quality capital, banks are better prepared to
withstand financial shocks.
- **Improved Transparency**: Stricter disclosure requirements lead to greater transparency, helping
market participants make more informed decisions.
- **Enhanced Confidence**: Stronger capital and liquidity positions enhance the overall confidence
in the banking sector.
